Stock correction, deflation, and two scenarios

Michael A. Gayed, CFA, winner of the 2014 Dow Award, is chief investment strategist and co-portfolio
manager at
Pension Partners, LLC., an
investment advisor which manages mutual funds and separate accounts according
to its ATAC (Accelerated Time and Capital) strategies focused on inflation
rotation. Prior to this role,
Gayed served as a portfolio manager for a large international investment group,
trading long/short investment ideas in an effort to capture excess returns. From
2004 to 2008, Gayed was a strategist at AmeriCap Advisers LLC, a registered
investment advisory firm that managed equity portfolios for large institutional
clients. In 2007, he launched his own long/short hedge fund,
using various trading strategies focused on taking advantage of stock market
anomalies. Follow him on Twitter @pensionpartners and YouTube
youtube.com/pensionpartners.

"The sky was clear - remarkably clear - and the twinkling of all the stars seemed to be but throbs of one body, timed by a common pulse." - Thomas Hardy

Markets in the U.S. continue to act choppy, but I maintain my stance that the odds of a correction are high given inter-market trend deterioration. Credit spreads are widening, dividend sectors are leading, small-caps are lagging, and emerging markets can't get a bid. Treasury yields appear to have stabilized, and Europe is faltering.

A casual look at the charts of Germany (EWG), Spain (EWP), emerging markets (EEM), China (FXI), and other country ETFs clearly shows that indeed a breakdown in many stock market averages is underway. Something is happening, and the behavior of overseas markets is making this more and more clear.

This is all about market behavior at turning points. Inter-market analysis suggests that this is a risky juncture for equities for those unwilling to look within markets in favor of absolute price levels. Is it a guarantee that a correction happens right here, right now? Absolutely not. The future is never about certainties and always about probabilities.

Those probabilities favor one of two scenarios. The first scenario is that U.S. stock averages fall, following the downtrend that is underway overseas in a lagged correction to risk sentiment. This would be a correction of price. The second scenario would be a period of volatile sideways action which results in frustration for bulls and bears, with no real returns being made either way. This would be a correction of time.

Indeed the inter-market deterioration I've been highlighting could resolve itself with markets not falling and just moving sideways. But this is not my base case. I do think stocks are likely to make a surprise decline. Why do I think so? Because a deflation pulse may start beating again.

I've chosen to show the relationship of financials to utilities because the two are at opposite ends of the economic scale.

Financials tend to outperform when reflation expectations are rising and a bullish environment exists for stocks. Utilities tend to outperform when deflation fears are rising, and volatility is expected to increase as money chases lower beta, less cyclical sectors. I have highlighted the various trends in the ratio to show how downtrends coincided with deflationary periods for equities, and uptrends coincided with risk-on junctures.

Note the far right of the chart where the ratio appears to be in the very early stages of rolling over. This would suggest, should the trend persist, that we are at the very beginning stages of a deflation pulse in markets, just in time for Dow 14,000.

If the relationship reverses sharply and other inter-market trends confirm, then correction risks diminish. However, this is not currently the case. Our ATAC models used for managing our mutual fund and separate accounts are indeed sensing this by being out of stocks.

Should this relationship continue to point downward, a correction of price becomes ever more likely than a correction of time. Either way, the risk lies in the former, not the latter. Until price says otherwise, I continue to stress that markets are primed for a surprise decline.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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